The Green Sheet Online Edition

June 09, 2014 • Issue 14:06:01

Employee versus independent contractor

By Vicki M. Daughdrill
Small Business Resources LLC

In previous articles, I discussed the hiring process itself. When deciding whether to hire an employee, it is essential to always consider whether you require an employee or can outsource the job to an independent contractor. Many small businesses rely on contractors. There are significant benefits to using independent contractors, including savings in labor costs, reduced liability, and flexibility in hiring and firing.

The IRS offers guidelines on whether workers can be classified as independent contractors or employees. This determination has significant tax consequences. An incorrect decision on the part of a business can result in great expense, plus considerable penalties and interest.

Expenses include reimbursement for wages you should've paid under the Fair Labor Standards Act, including overtime and minimum wage payments; back taxes and penalties for federal and state income taxes; Social Security, Medicare and unemployment contributions; payment of misclassified injured employees workers' compensation benefits; and provision of employee benefits, including health insurance and retirement account contributions.

When you hire employees, you have an obligation to withhold and pay federal income tax, Social Security and Medicare taxes, and federal unemployment insurance premiums in addition to any state or local taxes. You must also report wages to the proper reporting agencies and issue statements to each employee. In order to attract and retain outstanding employees, you may also need to provide a competitive benefits package to all employees. For independent contractors, generally no withholding is required, and the independent contractor is liable for all of the taxes described above.

What distinguishes an independent contractor from an employee? In general, an employee performs duties defined and structured by others, is trained on methods for completing the work, and works for only one employer. An independent contractor operates under a business name, has his or her own employees, maintains a separate business checking account, advertises his or her business' services, invoices for work completed, has more than one client, has his or her own tools, sets his or her own hours, and keeps business records.

Three primary categories

The courts have established three main categories when determining whether someone is an independent contractor or an employee. These categories are fully described in Publication 15-A and on the "Independent Contractor or Employee?" page on the IRS website. The categories are:

1. Behavioral control refers to whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done – as long as the employer has the right to do so. Factors include type of instructions given, degree of instruction, and evaluation systems and training. So if you hire someone, provide the necessary tools including telephones or computers, train the individual on how you want sales presentations to be done, and track the person's hours, the individual is an employee, not an independent contractor.
2. Financial control refers to whether a business has the right to control the economic aspects of the worker's job. These factors include whether the worker has a significant investment in the business; incurs unreimbursed expenses; has the opportunity for profit or loss; offers his or her services to the open market; and determines his or her terms of payment. Thus, if you hire someone and he or she works exclusively for you and meets the other financial criteria, the individual is an employee, not an independent contractor.
3. Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. The factors determining the type of relationship between two parties generally fall into the categories of written contracts, employee benefits, relationship permanency and services provided as key activities of the business.

Twenty questions

In addition, the IRS has provided 20 questions to help workers determine whether they are employees. The answers will reveal whether they can be classified as independent contractors or as employees.

1. Are you required to comply with instructions about when, where and how the work is to be done?
2. Does your client provide you with training to enable you to perform a job in a particular method or manner?
3. Are the services you provide integrated into your client's business operation?
4. Must the services be rendered by you personally?
5. Do you have the capability to hire,supervise or pay assistants to help you in performing the services under contract?
6. Is the relationship between you and the person or company you perform services for a continuing relationship?
7. Who sets the hours of work?
8. Are you required to devote your full time to the person or company you perform services for?
9. Must you perform the work at the place of business of the potential employer?
10. Who directs the order or sequence in which the work must be done?
11. Are you required to provide regular written or oral reports to your client?
12. What is the method of payment – hourly, commission or by the job?
13. Are your business and/or traveling expenses reimbursed?
14. Who furnishes tools and materials used in providing services?
15. Do you have a significant investment in facilities used to perform services?
16. Can you realize both a profit and a loss?
17. Can you work for a number of firms at the same time?
18. Do you make your services available to the general public?
19. Are you subject to dismissal for reasons other than nonperformance of contract specifications?
20. Can you terminate your relationship without incurring a liability for failure to complete a job?

For more information, visit www.irs.gov/pub/irs-pdf/p1779.pdf Independent Contractor or employee?

Bill Gates said, "Virtually every company will be going out and empowering their workers with a certain set of tools, and the big difference in how much value is received from that will be how much the company steps back and really thinks through their business processes." As you work to develop, grow and expand your business, step back and review your needs. Then determine whether you should hire an employee or an independent contractor.

Vicki M. Daughdrill is the Managing Member of Small Business Resources LLC, a management consulting company. E-mail her at vickid@netdoor.com or call her at 601-310-3594.

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